Wall Street Week Ahead: Fed may taper without causing market tantrum
QE tapering is already priced in. Now it is just a matter how much extra volatility will it cause when it becomes official
Everyone Is Saying The Fed Will Announce 'Taper-Lite' Next Week
If you read financial news or are connected to the markets in any way, shape, or form, you've undoubtedly heard of the "taper" – the yet-to-be-announced first reduction in the pace of monthly bond purchases the Federal Reserve makes under the quantitative easing program it introduced in September 2012.
All summer, the Wall Street consensus has been that the Fed will announce this first tapering at the conclusion of its September 17-18 FOMC policy meeting next week.
Right now, the Fed is buying $45 billion of U.S. Treasuries and $40 billion of mortgage-backed securities every month – $85 billion in total. For a while, Wall Street has expected the Fed to reduce that total by $15 billion at its September meeting.
In the past few weeks, though, the economic data – which the Fed claims guides its decision over whether or not to taper – has been coming in weaker than expected, casting some doubt on the idea of a reduction in QE.
So, Wall Street has adjusted its forecasts accordingly, and is now calling for "taper-lite" – that is, a reduction in bond purchases of only $10 billion per month, bringing the total to $75 billion instead of the previously-expected $70 billion.
In addition, many Wall Street economists expect the Fed to announce what they call a "dovish taper" next week.
This term refers to the idea that because a tapering announcement could roil stock and bond markets, the Fed will seek to offset the impact of the news with more market-friendly forward guidance on the future path of the Fed funds rate, which is currently pinned near zero.
The Fed's current forward guidance suggests that it won't raise rates until the unemployment rate has fallen below 6.5% (it currently stands at 7.3%).
As Goldman Sachs chief economist Jan Hatzius suggests, the Fed could "simply lower the 6.5% unemployment threshold," or "they could make the unemployment threshold depend on inflation and/or labor force participation; thus, inflation below 2% or a further decline in participation would imply a threshold of less than 6.5%."
In other words, a "dovish taper" involves the Fed promising to keep rates lower for longer alongside a reduction in bond purchases.
Voilà: the taper-lite dovish taper.
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Months of anticipation will come to an end next week when the Federal Reserve finally says whether it will start to rein in its massive stimulus of the economy, which has flooded financial markets with some $2.75 trillion over the past five years, supercharging returns on everything from stocks to junk bonds.
But for all the concerns that the reduced presence of such a giant asset buyer would be calamitous for investors, it appears equity and bond markets are poised to take next week's Fed decision largely in stride - provided the central bank doesn't surprise with the size of its move or shock in some other way.
The Fed has telegraphed its intentions to pare back its monthly purchases of $85 billion in bonds at its two-day meeting that ends next Wednesday. The scale of the tapering and what Fed Chairman Ben Bernanke might say at his press conference are key here, but the steady messaging in the last few months means next week probably won't see carnage in the markets.
Investors have already done a lot of work in absorbing the Fed's message. Benchmark bond yields are now hovering near two-year highs, while stocks have edged off highs reached in early August, removing some of the froth that had started to concern some investment strategists.
"The Fed already got tapering without actually tapering," said Daniel Heckman, senior fixed income strategist at U.S. Bank Wealth Management in Kansas City, Missouri.
Key measures of volatility and futures positioning show there is not much fear. The CBOE Volatility Index (^VIX), the market's favored gauge of Wall Street's anxiety, hovered around 14 on Friday, a level associated with calm markets.
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